BT Nationalisation and Promises, Promises

We are clearly in a run up to a General Election when politicians promise all kinds of “free” gifts to the electorate. The latest promise, even before the manifestos have been published, is the Labour Party’s commitment to give everyone in the UK free broadband. This would be achieved by simply nationalising BT Group (BT.A) apparently.

I just had a quick look at the cost of this commitment. BT actually receives over £15 billion annually according to the last accounts from Consumers and from Openreach. There is some profit margin on that of less than 20% which might be discounted, but there are many households who do not yet have a fibre connection so that would be an additional cost to be covered by the Government.

In addition there would probably be some cost of nationalising BT Group and paying compensation to shareholders. The current market cap of the company is about £19 billion. They might get away with paying £10 billion up front but the annual cost of at least £12 billion to maintain the network would be an enormous burden on the state. They might be able to raise that by taxing multinationals or others but it still makes no sense.

I am not a BT shareholder currently although I am one of their customers. I also remember how dreadful the service from BT was before it was nationalised. It may not be perfect now in comparison with some of their competitors but nationalised industries such as telecoms, the railways, the motor industry, the coal industry, shipbuilding, the gas/electric/water utilities and about 40 others were all abject failures. They typically lost money and provided diabolical service.  The young who are voting socialist may not remember but Jeremy Corbyn should do so.

The fact that the share price of BT only dropped by 1% today (at the time of writing) just shows you how much credibility investors attach to this promise. It also surely shows how desperate the Labour Party is to win some more votes as they are now trailing well behind in the opinion polls.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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How Damaging Would a Labour Government be to Water Companies?

The Labour Party has long argued that some utility companies should be renationalised and a prime target would be water companies if they got into power. If they were nationalised would current shareholders expect to get compensation and if so at what level? An article in the Financial Times over the weekend covered this issue and anyone holding the shares in water companies should be aware of the implications.

Shadow Chancellor John McDonnell said recently that he expected a compensation bill of only £14.8 billion based on paying the “book value” of the companies. That’s on the basis that shareholders should not be compensated for future profits, only what they have put into the business historically.

The two largest listed water companies are United Utilities (UU.) and Severn Trent (SVT). The comparison of the current market capitalisation of those companies with the book value (i.e. shareholders equity) shown on the last Annual Report Balance Sheet shows the following:

United Utilities: Book value: £2.95 billion, Market Cap: £5.56 billion.

Severn Trent: Book value: £0.99 billion, Market Cap: £4.76 billion.

In other words, shareholders might expect to receive only 21% of the current market share price in the case of Severn Trent and 53% in the case of United Utilities. The book value is not a basis for the valuation of companies because shareholders value companies on the basis of future profits, cash flows and dividends. The book value is, for most companies, of more interest to accountants than investors.

It would appear that the Labour Party would ignore the normal principles of independent valuation of companies and rig the valuation process to obtain the lowest possible figure. Is this legal one might ask or could it be challenged in law?

It’s worth pointing out that this is exactly what happened the last time the Labour Party was in power when Northern Rock and Bradford & Bingley were nationalised. In those cases shareholders received nothing because the valuation was based on artificial terms of reference. The valuer was forced to assume that they were worthless based on the companies having received financial support from the Government.

A fair valuation of any company is what a willing buyer is willing to pay a willing seller. In the case of listed companies, that is clearly what the market price of the shares is based upon. The shareholders in Northern Rock challenged the artificial assumption in the UK courts but lost in the Supreme Court based on the presumption that Parliament had the right to set the valuation assumptions. The European Court of Human Rights (ECHR) refused to hear the case.

So shareholders in the UK listed water companies need to consider these facts very carefully. The risk of future water company nationalisation seems not to have been reflected in the share prices of water companies even though Mrs May’s leadership of the Conservatives has improved the electoral chances of the Labour Party while Corbyn compounds the difficulties of the former by frustrating a decision on the Brexit Withdrawal Agreement with the apparent objective of prompting a General Election. How the politics will work out is anybody’s guess but those investors who have purchased shares in these companies because of their high dividend yields should surely not ignore the capital risk.

Institutional investors are some of those most exposed because you only have to look at the portfolios of high-income funds to see they are stacked up with the shares of such companies. Pension funds held by millions of people would be some of those most affected.

Let us hope that this threat never comes to pass.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Big Audit Firm Break-Up and Northern VCT AGM

A report commissioned by the Labour Party has advocated the break-up of the big four audit firms that dominate the audits of FTSE-350 firms. The report, co-authored by Prof. Prem Sikka et al, even goes so far as to suggest that their share of that market should be limited to 50% and that joint audits be promoted. In addition it argues that audit firms should be banned from doing non-audit work for the same company, and an independent body to appoint audit firms and agree their remuneration should be set up.

It also calls for the auditors to owe a duty of care to shareholders, not just the companies they audit, which would enable shareholders to pursue litigation over audit failings which they have great difficulty in doing at present. It is surely sensible to reinstate what was always assumed to be the case before the Caparo judgement.

These are revolutionary ideas indeed to try and tackle the problems we have seen in recent years and it seems to be now generally accepted by investors, if not the audit profession, that there have been too many major failings and the general standard is low. Even the Financial Report Council (FRC) seem to accept that view at a recent meeting with ShareSoc/UKSA.

But would breaking up the big four, effectively forcing some larger companies to use smaller audit firms improve the quality of audits? I rather doubt it. In my experience problems with smaller audit firms are just as common as in large ones – it’s just that the big companies and their audit failings get more publicity. Larger firms do have more expertise in certain areas and more international coverage. So there are good reasons to use them. But this report is certainly worth reading because if Mrs May continues to make a hash of Brexit and proves unable to stop dissension within her party we may see a Labour Government looking to implement these policies. See http://visar.csustan.edu/aaba/LabourPolicymaking-AuditingReformsDec2018.pdf . I may make more comments on the report after I have read the whole 167 pages.

Note that this issue of audit firm size came up at the Northern Venture Trust (NVT) Annual General Meeting which I attended today. This is a long-established Venture Capital Trust – it was their 23rd AGM, many of which I have attended. One shareholder voted against the reappointment of KPMG on the “show of hands” vote, and there were 1.2million votes against them on the proxy counts (versus 10.9 million “for”). It is unusual to see so many voted against such resolutions. When I asked the shareholder why he voted against I was told it was because he thought that a smaller audit firm might do better as VCTs are relatively smaller investment companies. However I pointed out that VCT legislation is very complex so it makes sense to use an audit form that is more knowledgeable in that regard.

The other possible reason for high proxy votes against the auditors is that Nigel Beer, who chairs the Audit Committee is a former partner in KPMG although he told me later that he had departed many years ago. Anyway I did raise this issue in the meeting and the fact that both Nigel Beer and Hugh Younger had just passed 9 years of time on their board. In addition, Tim Levett, who is Chairman of NVM, the fund manager, is on the board. So according to the UK Corporate Governance Code that’s three directors out of 6 who should be considered non-independent.

I urged the Chairman to look at “refreshing” the board although I did not doubt their experience and knowledge. It was also pointed out to me after the meeting that there are no women on the board. So effectively this is really a stale, male, pale board. However the Chairman said they do regularly review board structure and succession.

Other than that there were some interesting comments given by Tim Levett in his presentation. He said that due to the change in the VCT rules in 2016 they have changed from being a late stage investor to being an early stage one. In the last 3 years they have built a new portfolio of 22 early stage companies and are probably the most active generalist VCT manager other than Titan. NVM have opened a new office in Birmingham and built up the Reading office. There were also a number of new staff who were introduced at the meeting.

He also said that like all the top 10 VCTs, an awful lot of special dividends had been paid in the last three years. This was because of realisations and the VCT rules that prevented them from retaining cash. This has meant a reduction in the NAV of the trust but in future they will try and maintain that at the same time as maintaining a 5% dividend. Note: that historically it means that capital has been paid out in tax-free dividends that investors might have reinvested in the trust and hence collected a second round of up-front income tax relief. One can understand why the trust does not want to continue doing that as it may otherwise spark some attention from HMRC. I also prefer to see VCTs maintain their NAV as otherwise the trusts shrink in size which can create problems in due course as we have seen with other VCTs.

NVT are doing a new share issue in January which will of course improve their NAV and I was glad to hear that at least some of the directors will be taking up shares in the offer and adding to their already considerable holdings. That inspires some confidence that they can cope with the changes to the VCT rules that mean there will be more emphasis on investing in riskier early stage companies.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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